Country and Area Studies

Israel's economic performance over the past decade has been impressive. The combination of recent structural reforms and huge investments in R&D has led to a high-tech boom. Israeli political and business leaders deserve credit for their successes. Many difficult reforms were enacted and much of the foundation for future economic growth has already been laid. Indeed, its successes have catapulted Israel into the top ranks of the developed world's economies. But Israel's new peers are formidable competitors, and Israel cannot rest on its laurels.

Many other countries have also had impressive economic performances over the past 10 years and have grown faster and delivered greater gains to their citizens than Israel. In this regard, Israel is like a global corporation in danger of complaisance over its growth without realizing that it is losing market share and could well find itself facing an unexpected crisis.

The fact that global competition from new quarters like China and India is more pressing by the day and that the favorable circumstances of the past decade are not likely to last, only increase this danger. Furthermore, not all sectors of the Israeli economy have performed well recently, and the social and demographic challenges facing Israel are daunting, to say the least.

Now is therefore the time to set out a strategy for the future. It is much better to enact further reforms from a position of strength when times are good, than to try to respond unprepared in the midst of crises.

To assess the reality of Israel's performance and to help shape thinking about how and along what lines to develop an economic strategy for the future, the Economic Strategy Institute has been conducting a benchmarking exercise that compares Israel's economic performance to those of Singapore, Taiwan, Ireland, Sweden, Finland, and Estonia.

Benchmarking Conclusions

These countries represent several different models. Sweden and Finland are the quintessential Scandinavian welfare states with high taxes, big government, and large safety nets. Estonia is a former socialist country that has gone capitalist in a serious way. Taiwan and Singapore have historically provided little welfare and virtually no safety nets. Ireland sits somewhere in the middle. Some have long been democracies with the experience of frequent changes of government. Others have been less classically democratic. Yet, despite these very different approaches, the keys to success have been very similar for all.

1. All have perceived economic development and competitiveness to be a matter of national security and have given them the same kind of priority that the United States and Israel give to military matters. All have established elite economic planning and coordinating bodies that analyze their international economic competitiveness and then implements policies for optimization across the board.

2. All have adopted export led growth strategies.

3. All have adopted policies to continuously raise the level of sophistication and technology of their export industries. Some have done this by developing indigenous capabilities and companies (Sweden, Taiwan, and Finland). Others have done it by attracting foreign MNCs to invest within their borders (Singapore, Ireland, and Estonia). But the movement to higher ground is common.

4. All have done the fundamentals well. They have fiscal discipline, budget surpluses or very small deficits, clean government, little corruption, rule of law, high quality and reasonably well paid civil servants, high rates of saving and investment, low inflation, excellent infrastructure (in most cases), and an emphasis on education.

5. All have a high degree of social and political cohesion. In some cases (Singapore) this was not the natural beginning state, but has been rather the result of wise policy.

6. All have achieved peace between government, management, and labor and enjoy very flexible wage setting circumstances.

7. All have managed their currency exchange rates in such a way (so far) as to facilitate their export led growth strategies. (This may be breaking down for those countries that have adopted the Euro).

8. All have provided a stable environment for investment. Although governments in several have changed, the policies have remained mostly unchanged thus reducing the risk of long term investment.

9. All have adopted tax regimes that favor business and investment. Even though Finland and Sweden, for example, are thought of as high tax countries, their corporate tax rates are far below those of Israel and most other countries. In fact, they have very favorable tax environments for business.

Outlook for Israel

Israel has several competitiveness issues that need to be addressed:

1. First, while the high tech sector is strong, the broader Israeli economy is not accruing as many gains as it should from this strength. Too many high-tech entrepreneurs are focusing on exit strategies rather than growing their businesses into successful stand alone firms. There are too few jobs being created, too few exports, and too little investment in future capacity.

2. Second, Israel must improve its labor force participation rate. Low participation rates are the cause of Israel's high levels of poverty, as well as the widening inequalities seen in society. Two groups in particular need help: the Israeli Arabs and the Ultra-Orthodox. These communities need a variety of assistance, from improved infrastructure to more market oriented education, to vocational training and subsidized child care. Reducing transfer payments to these groups could also provide incentives for them to join the workforce, as should reducing the number of foreign workers in the economy, as they compete with the unskilled for jobs and push down wages.

3. Third, Israel's service sector has not approached its potential in terms of increased productivity growth, rising employment, or efficient provisioning of services.

4. Fourth, the public sector needs to vastly improve its transparency and efficiency. Corruption scandals are becoming all too frequent occurrences in Israel and the number and scope of regulations covering the business sector are inhibiting growth.

5. Fifth, Israel must continue structural reforms in the area of labor.

6. Finally, Israel's infrastructure is merely adequate, and requires sustained long term investments to bring its port, rail, road, and telecommunication infrastructure up to world class standards.

Main Recommendations:

1. Make competitiveness as important as security because ultimately it is the only security.

2. Establish a National Competitiveness Council chaired by the Prime Minister, and charge this council with completing an annual assessment of the nation's competitiveness.

3. Create an Agency for Economic Development that would be linked to the Council and that would do the analysis and establish the economic strategy guidelines. This Agency would also have an arm dedicated to attracting foreign investment and an arm dedicated to fostering long term domestic investment. (both of these are variations on the existing concept of the Chief Scientist)

4. Also part of the Agency would be a Technology Extension Service that would be dedicated to spreading the latest technology and techniques widely throughout the economy so that low tech can be leveraged by high tech.

5. Achieve a Social Stability Pact that creates an understanding between labor, management, and government and that includes a mechanism for continuous coordination and consensus building between these communities. Israel must achieve the same kind of labor flexibility as its leading competitors. Part of the solution here could be modeled on the Danish flexicurity system.

6. Create a required core national curriculum for all primary and secondary schools of all ethnic and religious groups. Improve the quality of the schools and even it out over the entire school system.

7. Require a form of national service from all ethnic and religious groups even if they do not perform military service.

8. Charge the Bank of Israel with managing not only for inflation but also for full employment and export led growth.

9. Put big emphasis on development of the tourist industry as a way of providing employment to the large number of people who will not become rocket scientists.

10. Create a "czar" to oversee comprehensive upgrading of the entire national infrastructure.

11. Reduce corporate taxes to Irish levels. Raise short term capital gains taxes to high levels but abolish long term capital gains taxes. Impose consumption levies (VAT) and a carbon tax the proceeds of which will be used to upgrade the infrastructure. For personal taxes, establish a progressive flat tax a la Estonia.

Other Recommendations:

Israel should work more closely with the EU. It should apply to join the EFTA; it should adopt as many parts of the Acquis Communitaire as possible, and it should adopt EU technical standards wherever possible.

Transfer and welfare payments should be changed so that they provide incentives to get back to work. So for example, direct cash payments should be lowered, while spending on child care, worker retraining, adult education, and vocational programs should all be increased.

Israel's infrastructure planning and spending should be designed with a view to integrating the West Bank and Gaza with Israeli infrastructure. Israel could also benefit from Gulf or European money spent on infrastructure investments in the Territories as part of a peace process.

Estonian e-services and national identity cards are a model for efficient public services (as are their relatively simple and straightforward regulations.)